For Canadian investors, carbon-free portfolio a tricky task

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The landscape of ethical investing has grown over the years from guns, booze and tobacco to include issues such as executive compensation and the environment. If a carbon-free portfolio, for instance, is a priority, then it's easy to find a mutual fund that will cater to your investing needs. That is, of course, unless you're an index investor in Canada. In that case, balancing an investing philosophy with ethical considerations becomes trickier.

Riding the river with the ups and downs of the TSX, as index investors such as myself choose to do, may seem like a passive investing strategy, but in reality it's actually a big bet on carbon-based stocks. The energy index, along with coal and pipeline companies, accounts for some 30 per cent of the Canadian market. That means if you buy into the TSX, you're long carbon, full stop. Philosophical considerations aside, should index investors be comfortable with such a heavy weighting of energy stocks in their portfolio? As ever, there are short, medium, and long-term issues at play.

The so-called bitumen bubble has stopped making headlines, but that doesn't mean it has disappeared. The cash flow of much of the country's energy sector still depends on how much refiners are willing to pay for Canadian barrels. The combination of increasing production from the oil sands and shrinking North American demand still makes Canadian oil a bargain. The benchmark price of Western Canadian Select shows that Canadian oil remains among the cheapest crude to be found anywhere, trading at more than $30 below world oil prices. Closing that price discount will take a major new pipeline project, such as Keystone XL, Northern Gateway or Energy East.

Investors in Canada's oil sector are currently putting considerable faith in rail, whether they realize it or not. The more oil that can be loaded onto rail cars and shipped to refineries, the more the price discount between Canadian oil and the rest of the world will shrink.

By last month's count, more than a million barrels a day are now being moved around North America by rail. Much of that crude ends up in coastal refineries where it's processed into gasoline bound for markets in Latin America, the Middle East and West Africa. Without a major new pipeline project going ahead, the amount of oil being shipped by rail could double in the next five years, as production from prolific shale oil plays in North Dakota, Texas, and elsewhere continues to rise. Rail stocks, for their part, are becoming so dependent on the money generated from carrying oil, investors could well start regarding them as a de facto part of the energy sector.

But oil-by-rail is certainly not without its costs. As the recent train derailment in Alberta reminds us, another tragedy, such as Lac-Mégantic, continues to be a possibility as oil continues to be moved around the continent in ever-greater amounts. From a purely investing standpoint, if a derailment happened near a major city the ensuing lawsuits against rail companies could quickly take the lustre off the currently profitable business of moving oil. Railways may lose their appetite for shipping crude, as insurance and other costs go up. If moving barrels around by rail becomes less of an option, Canada's oil sands producers will once again find the supply and demand dynamics of North America's oil markets moving sharply against them.

In the longer term, the market value of Canada's energy sector (as I argue here) also faces a formidable challenge from the carbon trail that will be left by burning reserves. Among the many impacts of climate change, financial markets will begin re-evaluating the value of oil, natural gas, and coal reserves.

The latest report from the Intergovernmental Panel on Climate Change warns that the world can only burn so much more carbon before crossing critical thresholds that will put a warming planet into even worse shape. The IPCC says we only have room to burn about a fifth of the oil, gas and coal reserve currently on the books. That means four out of every five tons of carbon reserves could become stranded assets with little economic value. At some point, an adjustment to how energy firms are valued by the market will need to be made. Is the TSX being inflated by a long-term carbon bubble? If so, investors need to think about where they want to be when it pops.

Jeff Rubin is a former chief economist of CIBC World Markets and the author of the award-winning Why Your World Is About To Get A Whole Lot Smaller as well as The End of Growth.